Measures of Dividend Policy 154 Dividend Payout = Dividends/ Net Income Measures the percentage of earnings that the company pays in dividends If the net income is negative, the payout ratio cannot be computed. Dividend Yield = Dividends per share/ Stock price Measures the return that an investor can make from dividends alone Becomes part of the expected return on the investment. 154
Dividend Payout Ratio: January 2017 155 Payout Ratios at the start of 2017: US and Global Firms 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% <10% 10-20% 20-30% 30-40% 40-50% 50-60% 60-70% 70-80% 80-90% 90-100% >100% US Global 155
Dividend Yields: January 2017 156 Dividend Yields at the start of 2017: US & Global 0.16 0.14 0.12 0.1 Broad Group 25th Perc. Median 75th Perc. Australia, NZ and Canada 1.77% 3.39% 5.09% Developed Europe 1.62% 2.84% 4.68% Emerging Markets 0.88% 2.27% 4.62% Japan 1.33% 2.08% 2.81% United States 1.17% 2.12% 3.47% 0.08 0.06 0.04 0.02 0 <.5%.5-1% 1-1.5% 1.5-2% 2-2.5% 2.5-3% 3-3.5% 3.5-4% 4-4.5% 4.5-5% 5-5.5% 5.5-6% 6-6.5% 6.5-7% 7-7.5% 7.5-8% >8% US Global 156
157
158 Dividend Yields and Payout Ratios: Growth Classes Dividend Yields and Payout Ratios: By Growth Class 50.00% 4.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% Dividend Payout ratio Dividend Yield 0.00% 0-3% 3-5% 5-10% 10-15% 15-20% 20-25% >25% 0.00% 158
Dividend Policy: Disney, Vale, Tata Motors, Baidu and Deutsche Bank 159 Disney Vale Tata Motors Baidu Deutsche Bank Dividend Yield - Last 12 months 1.09% 6.56% 1.31% 0.00% 1.96% Dividend Payout ratio - Last 12 months 21.58% 113.45% 16.09% 0.00% 362.63% Dividend Yield - 2008-2012 1.17% 4.01% 1.82% 0.00% 3.14% Dividend Payout - 2008-2012 17.11% 37.69% 15.53% 0.00% 37.39% 159
Three Schools Of Thought On Dividends 1. If there are no tax disadvantages associated with dividends & companies can issue stock, at no issuance cost, to raise equity, whenever needed Dividends do not matter, and dividend policy does not affect value. 2. If dividends create a tax disadvantage for investors (relative to capital gains) Dividends are bad, and increasing dividends will reduce value 3. If dividends create a tax advantage for investors (relative to capital gains) and/or stockholders like dividends Dividends are good, and increasing dividends will increase value 160
The balanced viewpoint 161 If a company has excess cash, and few good investment opportunities (NPV>0), returning money to stockholders (dividends or stock repurchases) is good. If a company does not have excess cash, and/or has several good investment opportunities (NPV>0), returning money to stockholders (dividends or stock repurchases) is bad. 161
The Dividends don t matter school The Miller Modigliani Hypothesis 162 The Miller-Modigliani Hypothesis: Dividends do not affect value Basis: If a firm's investment policies (and hence cash flows) don't change, the value of the firm cannot change as it changes dividends. If a firm pays more in dividends, it will have to issue new equity to fund the same projects. By doing so, it will reduce expected price appreciation on the stock but it will be offset by a higher dividend yield. If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains. Underlying Assumptions: (a) There are no tax differences to investors between dividends and capital gains. (b) If companies pay too much in cash, they can issue new stock, with no flotation costs or signaling consequences, to replace this cash. (c) If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions. 162
II. The Dividends are bad school: And the evidence to back them up 163 Figure 10.10: Tax rates on Dividends and Capital Gains- US 100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% Difference between dividend tax rate & capital gains peaks at 66% in 1950s. Dividends & capital gains taxed at same rate since 2003. 0.00% 2015 2013 2011 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 1960 1958 1956 1954 1952 1950 1948 1946 1944 1942 1940 1938 1936 1934 1932 1930 1928 1926 1924 1922 1920 1918 1916 Dividend tax rate Capital gains tax rate 163
164 What do investors in your stock think about dividends? Clues on the ex-dividend day! Assume that you are the owner of a stock that is approaching an exdividend day and you know that dollar dividend with certainty. In addition, assume that you have owned the stock for several years. Initial buy At $P P b Ex-dividend day P a Dividend = $ D P = Price at which you bought the stock a while back P b = Price before the stock goes ex-dividend P a =Price after the stock goes ex-dividend D = Dividends declared on stock t o, t cg = Taxes paid on ordinary income and capital gains respectively 164
Cashflows from Selling around Ex-Dividend Day 165 The cash flows from selling before ex-dividend day are: P b - (P b - P) t cg The cash flows from selling after ex-dividend day are: P a - (P a - P) t cg + D(1-t o ) Since the average investor should be indifferent between selling before the ex-dividend day and selling after the ex-dividend day - P b - (P b - P) t cg = P a - (P a - P) t cg + D(1-t o ) Some basic algebra leads us to the following: P b P a D = 1 t o 1 t cg 165
Intuitive Implications 166 The relationship between the price change on the exdividend day and the dollar dividend will be determined by the difference between the tax rate on dividends and the tax rate on capital gains for the typical investor in the stock. Tax Rates If dividends and capital gains are taxed equally If dividends are taxed at a higher rate than capital gains If dividends are taxed at a lower rate than capital gains Ex-dividend day behavior Price change = Dividend Price change < Dividend Price change > Dividend 166
The empirical evidence 167 1966-1969 Ordinary tax rate = 70% Capital gains rate = 28% Price change as % of Dividend = 78% 1981-1985 Ordinary tax rate = 50% Capital gains rate = 20% Price change as % of Dividend = 85% 1986-1990 Ordinary tax rate = 28% Capital gains rate = 28% Price change as % of Dividend = 90% 167
Dividend Arbitrage 168 Assume that you are a tax exempt investor, and that you know that the price drop on the ex-dividend day is only 90% of the dividend. How would you exploit this differential? a. Invest in the stock for the long term b. Sell short the day before the ex-dividend day, buy on the ex-dividend day c. Buy just before the ex-dividend day, and sell after. d. 168
169 Example of dividend capture strategy with tax factors XYZ company is selling for $50 at close of trading May 3. On May 4, XYZ goes ex-dividend; the dividend amount is $1. The price drop (from past examination of the data) is only 90% of the dividend amount. The transactions needed by a tax-exempt U.S. pension fund for the arbitrage are as follows: 1. Buy 1 million shares of XYZ stock cum-dividend at $50/share. 2. Wait till stock goes ex-dividend; Sell stock for $49.10/share (50-1* 0.90) 3. Collect dividend on stock. Net profit = - 50 million + 49.10 million + 1 million = $0.10 million 169
Two bad reasons for paying dividends 1. The bird in the hand fallacy 170 Argument: Dividends now are more certain than capital gains later. Hence dividends are more valuable than capital gains. Stocks that pay dividends will therefore be more highly valued than stocks that do not. Counter: The appropriate comparison should be between dividends today and price appreciation today. The stock price drops on the ex-dividend day. 170
2. We have excess cash this year 171 Argument: The firm has excess cash on its hands this year, no investment projects this year and wants to give the money back to stockholders. Counter: So why not just repurchase stock? If this is a one-time phenomenon, the firm has to consider future financing needs. The cost of raising new financing in future years, especially by issuing new equity, can be staggering. 171
The Cost of Raising Capital 172 Figure 10.12: Issuance Costs for Stocks and Bonds 25.00% 20.00% Cost as % of funds raised 15.00% 10.00% 5.00% 0.00% Under $1 mil $1.0-1.9 mil $2.0-4.9 mil $5.0-$9.9 mil $10-19.9 mil $20-49.9 mil $50 mil and over Size of Issue Cost of Issuing bonds Cost of Issuing Common Stock 172
Three good reasons for paying dividends 173 Clientele Effect: The investors in your company like dividends. The Signalling Story: Dividends can be signals to the market that you believe that you have good cash flow prospects in the future. The Wealth Appropriation Story: Dividends are one way of transferring wealth from lenders to equity investors (this is good for equity investors but bad for lenders) 173
1. The Clientele Effect The strange case of Citizen s Utility 174 Class A shares pay cash dividend Class B shares offer the same amount as a stock dividend & can be converted to class A shares 174
Evidence from Canadian firms 175 Company Premium for cash dividend shares Consolidated Bathurst + 19.30% Donfasco + 13.30% Dome Petroleum + 0.30% Imperial Oil +12.10% Newfoundland Light & Power + 1.80% Royal Trustco + 17.30% Stelco + 2.70% TransAlta +1.10% Average across companies + 7.54% 175
A clientele based explanation 176 Basis: Investors may form clienteles based upon their tax brackets. Investors in high tax brackets may invest in stocks which do not pay dividends and those in low tax brackets may invest in dividend paying stocks. Evidence: A study of 914 investors' portfolios was carried out to see if their portfolio positions were affected by their tax brackets. The study found that (a) Older investors were more likely to hold high dividend stocks and (b) Poorer investors tended to hold high dividend stocks 176
Results from Regression: Clientele Effect Dividend Yieldt= a+ b bt+ c Aget+ d Incomet+ edifferential Tax Ratet+ et Variable C oefficient I mplies Constant 4.22% Beta Coefficient -2.145 Higher beta stocks pay lower dividends. Age/100 3.131 Firms with older investors pay higher dividends. Income/1000-3.726 Firms with wealthier investors pay lower dividends. Differential Tax Rate -2.849 If ordinary incomeis taxed at a higher rate than capital gains, thefirmpays less dividends.
Dividend Policy and Clientele 178 Assume that you run a phone company, and that you have historically paid large dividends. You are now planning to enter the telecommunications and media markets. Which of the following paths are you most likely to follow? a. Courageously announce to your stockholders that you plan to cut dividends and invest in the new markets. b. Continue to pay the dividends that you used to, and defer investment in the new markets. c. Continue to pay the dividends that you used to, make the investments in the new markets, and issue new stock to cover the shortfall d. Other 178
2. Dividends send a signal Increases in dividends are good news.. 179 179
180 But higher or new dividends may signal bad news (not good) Dividend Initiations and Earnings Growth 45.00% 40.00% 35.00% Annual Earnings Growth Rate 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -4-3 -2-1 1 2 3 4 Year relative to dividend initiation (Before and after) 180
Both dividend increases and decreases are becoming less informative Market Reaction to Dividend Changes over time: US companies 1.00% 0.00% 1962-1974 1975-1987 1988-2000 -1.00% -2.00% Dividend Increases Dividend Decreases -3.00% -4.00% -5.00% -6.00%
3. Dividend increases may be good for stocks but bad for bonds.. EXCESS RETURNS ON STOCKS AND BONDS AROUND DIVIDEND CHANGES 0.5 Stock price rises CAR 0 t:- -0.5 15-1 -12-9 -6-3 0 3 6 9 12 15 CAR (Div Up) CAR (Div down) -1.5-2 Bond price drops Day (0: Announcement date)
What managers believe about dividends 183 183
184 ASSESSING DIVIDEND POLICY: OR HOW MUCH CASH IS TOO MUCH? It is my cash and I want it now
The Big Picture 185 Maximize the value of the business (firm) The Investment Decision Invest in assets that earn a return greater than the minimum acceptable hurdle rate The Financing Decision Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations The Dividend Decision If you cannot find investments that make your minimum acceptable rate, return the cash to owners of your business The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it. The return should reflect the magnitude and the timing of the cashflows as well as all side effects. The optimal mix of debt and equity maximizes firm value The right kind of debt matches the tenor of your assets How much cash you can return depends upon current & potential investment opportunities How you choose to return cash to the owners will depend on whether they prefer dividends or buybacks 185
Assessing Dividend Policy 186 Approach 1: The Cash/Trust Nexus Assess how much cash a firm has available to pay in dividends, relative what it returns to stockholders. Evaluate whether you can trust the managers of the company as custodians of your cash. Approach 2: Peer Group Analysis Pick a dividend policy for your company that makes it comparable to other firms in its peer group. 186
I. The Cash/Trust Assessment 187 Step 1: How much did the the company actually pay out during the period in question? Step 2: How much could the company have paid out during the period under question? Step 3: How much do I trust the management of this company with excess cash? How well did they make investments during the period in question? How well has my stock performed during the period in question? 187
How much has the company returned to stockholders? 188 As firms increasing use stock buybacks, we have to measure cash returned to stockholders as not only dividends but also buybacks. For instance, for the five companies we are analyzing the cash returned looked as follows. Disney Vale Tata Motors Baidu Deutsche Bank Year Dividends Buybacks Dividends Buybacks Dividends Buybacks Dividends Buybacks Dividends Buybacks 2008 $648 $648 $2,993 $741 7,595 0 0 0 2,274 0 2009 $653 $2,669 $2,771 $9 3,496 0 0 0 309 0 2010 $756 $4,993 $3,037 $1,930 10,195 0 0 0 465 0 2011 $1,076 $3,015 $9,062 $3,051 15,031 0 0 0 691 0 2012 $1,324 $4,087 $6,006 $0 15,088 970 0 0 689 0 2008-12 $4,457 $15,412 $23,869 $5,731 51,405 970 0 0 4,428 0 188
189 A Measure of How Much a Company Could have Afforded to Pay out: FCFE The Free Cashflow to Equity (FCFE) is a measure of how much cash is left in the business after non-equity claimholders (debt and preferred stock) have been paid, and after any reinvestment needed to sustain the firm s assets and future growth. Net Income + Depreciation & Amortization = Cash flows from Operations to Equity Investors - Preferred Dividends - Capital Expenditures - Working Capital Needs = FCFE before net debt cash flow (Owner s Earnings) + New Debt Issues - Debt Repayments = FCFE after net debt cash flow 189